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How Fear Kills Your Returns

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I had the pleasure of teaming up with my buddy and comedic genius/Fool Dan Rubin (BroadwayDan) to write this article for the Fool. In addition to getting me hooked on Shark Tank, Dan is a quality individual with a knack for all things Foolish. I hope we're able to collaborate on more pieces going forward.

The questions poised in this article are key. I grew extremely frustrated with my investments in 2008 and 2009, partly for political/economic reasons (bummed with the bailouts, stimulus, etc.) as well as being discouraged with my sluggish returns since I started investing in 2005. When you find yourself getting discouraged with stocks, that is usually an indicator that you should especially be investing in stocks at that point in time.

Buffett's adage to be fearful when others are greedy and greedy when others are fearful is a good one to practice. I learned the hard way that if you ignore stocks due to discouragement, you will likely miss the ideal time to be investing in stocks (as evidenced by the market's stellar performance over the past 4-5 years). This is because you are likely not the only investor who is discouraged. A mass exodus from the market due to discouraged and/or shortsighted investors can cause many businesses to fall to discount levels (and, therefore, be exactly the ideal time for us to be investing rather than leaving the market).

By building a portfolio of quality businesses, we can begin to look past the hype and short-term market volatility. The examples provided in this article exemplify why short-term drops alone (even 50% or more) should not phase long-term investors focused on the underlying business behind each stock.

As investors, we're often taught to control our emotions. But this is easier said than done. Why is that?

The reason is that for hundreds of thousands of years, human beings adapted to a world where our immediate survival was threatened daily by predators, bad weather, and opposing clans who would gladly haul off our mates, steal our food, and club us to death. In response to these threats, our bodies have learned to flood our bodies with hormones, priming us to fight or take flight.

The problem is that our brains have evolved to help us survive in a world we no longer live in. Independent educator Josh Kaufman notes in his summary of John Medina's fascinating book Brain Rules: "Since we're trying to run modern software on ancient hardware, our prehistoric brains constantly magnify perceived threats and overlook opportunities. That's why humans often do so many irrational and inefficient things."

What goes up must come down?

With the market rallying for the past several years, many of us are sitting on meaningful gains in popular stocks like Activision Blizzard (ATVI), Netflix (NFLX), and Under Armour (UA). While these gains should instill feelings of joy and inner peace, they often create anxiety. We are hardwired to defend what we've acquired. Ever feel your heart race or your palms sweat as you listen to an expert explain why your investment is massively overvalued and sure to take a 50% to 75% haircut?

You've got kids to put through college, retirements to fund, and plumbing to fix. What if Activision Blizzard's Destiny flops? What if the government kills net neutrality and drives up costs for Netflix, and the company can't pass those costs along to customers? What if men become sensitive to the fact that Under Armour shirts expose their "man boobs"? These worries can quickly paralyze you with fear -- much like saber-toothed tigers once did to our ancestors.

Focus on the fundamentals

"Unless you can watch your stock holding decline by 50% without becoming panic-stricken," says Warren Buffett, "you should not be in the stock market." Long-term investors embrace the inevitable short-term volatility of the stock market.

Activision Blizzard shares were cut by more than half in 2008, yet the stock has still gained more than 1,200% over the past decade. Activision's experienced and innovative leadership -- guided by chairman Brian Kelly and CEO Robert Kotick, both of whom have been with Activision since 1991 -- have rewarded patient long-term investors with astounding market-beating returns.

Netflix investors have been similarly rewarded under the innovative leadership of co-founder, chairman, and CEO Reed Hastings, with the stock returning more than 1,100% since 2004. In 2011, however, Netflix shares fell 60% after the company announced its intentions to split its DVD-by-mail and Internet streaming services (the "Qwikster debacle"). Facing immediate backlash after announcing this decision, Hastings and company quickly changed course and announced that the DVD and instant-streaming services would remain under the same roof. The stock has since increased more than 500%.

Shares of Under Armour have increased more than 800% since the company went public in 2005. However, after three years of trading publicly, the stock was down 50%. Short-term traders and emotional investors would be quick to throw the company under the bus, while patient long-term investors have been rewarded with a market-beating investment under the leadership of founder, chairman, and CEO Kevin Plank.

In all three cases, these businesses continue to be led by experienced and innovative management teams. For patient investors with a long-term outlook -- five to 10 years and beyond -- Activision, Netflix, and Under Armour are prime candidates to continue to deliver market-beating returns over the long haul.

Questions of balance

Before you race to sell your winners, take a moment to calmly consider some questions. What is the time frame of your investment? Has the story behind the stock changed? Has the CEO's vision for the company changed? Do you still trust the integrity of management? Has the world changed so much that your company's products are obsolete?

Ask yourself what exactly will happen if your stock gives up a portion, if not all, of its gains. Will you be financially ruined? Unless you've bet the farm, the answer is no.

As you consider these questions, bear in mind that a failed investment does not make you a failed investor.

Know yourself and move from there

You may ultimately decide that individual stocks cause you too much anxiety. This is a valid reason to take profits and move into an index or mutual fund. But for investors with well thought-out stock picks, diversified holdings, and long-term time horizons, price drops mean only a change in the number on a computer screen -- not the long-term viability of a business or investment thesis. In fact, we would argue that this presents an opportunity to add to a worthy investment at a discounted price.